A highly anticipated event in the financial world each year is the release of legendary investor and Berkshire Hathaway Chairman Warren Buffett’s annual letter to the company’s shareholders. Market watchers and other observers value Buffett’s annual letter for its valuable insights about the financial marketplace, as well as for Buffett’s homespun humor and his wise insights about the economy and the world. In this year’s letter (here), which the company released on Saturday morning, Buffett had quite a bit to say about the current prospects of the American economy. Many of Buffett’s remarks about the U.S. economy were expressly intended to counter the relentlessly negative tone of the current U.S. Presidential election campaign. The letter also contains an interesting commentary about both the beneficial and disruptive effects resulting from gains in productivity; the commentary includes a cautionary note about the need to assist those disadvantaged by the rapid changes that often accompany technical innovations. The letter also contains a rather sobering assessment of the risks the world currently faces. (Full disclosure: I own BRK.B shares, though not nearly as many as I wish I did.)
Observers were particularly interested in the 2015 version of Buffett’s annual letter because, some commentators believed, the past year had been a “down year” or “off year” due to plummeting oil prices and the declining value of some of the company’s top equity investments, including American Express and IBM. However, Buffett’s letter doesn’t waste much time worrying about the fact that Berkshire’s share price performance lagged the S&P 500 last year. He is much more interested in the growth in the company’s “intrinsic value,” both because of the overall increase in the value of many of Berkshire’s holdings, but also because of the increase in the company’s aggregate net earnings.
For starters, he noted that with respect growth of the company’s “normalized” earnings (normalized to account for the impact on the company’s insurance business due to catastrophe events), 2015 was, according to Buffett, a “good” year. The company’s per share earning increased 2.1% to $12,304 per share (inclusive of underwriting income, but excluding dividend and interest income from the company’s investments), and the per-share value of the company’s cash and investments increase 8.3% to $159,794. The company’s net worth grew $15.4 billion in 2015, representing an increase of 6.4%. The company ended the year with $61.8 billion in cash on the books (up fro $58 billion at the end of 2014.)
Buffett also noted that the company’s financial results for the current year will be affected by impacts from the company’s $32 billion acquisition of Precision Castparts Corp., which is by far the largest acquisition Berkshire has ever made, and which closed last month. With the PCC acquisition, Berkshire now owns 10 companies which, if standing alone, would be included in the S&P 500 (as well as 27% of Kraft Heinz).
However, most of those who read Buffett’s annual letter are not interested as much in his analysis of his company’s performance as they are in what Buffett has to say about more general issues. In that regard, the latest letter does not disappoint.
I wondered if Buffett might have something to say about the current Presidential election campaign. It turns out that Buffett does indeed have something to say about the candidates who “can’t stop talking about our country’s problems (which, of course, only they can solve).” As a result of this “negative drumbeat,” many Americans “now believe that their children will not live as well as they themselves do.” That view, Buffett says, is “dead wrong”; in fact, “the babies being born in America today are the luckiest crop in history.”
America’s GDP has grown six-fold since Buffett was born in 1930, and the trend toward GDP growth is “certain” to continue. America’s “economic magic” remains “live and well.” While some may bemoan our current 2% annual growth in real GDP, the compounding effect of even this modest growth level means that real GDP per capita will grow 34.4% in the next 25 years. Today’s politicians, Buffett says, “need not shed tears for tomorrow’s children.” For emphasis, he adds, “yes, America’s kids will live far better than their parents did.” For 240 years, “it’s been a terrible mistake to be against America, and now is not time to start.”
For all of this optimism about America’s future, Buffett’s letter acknowledges that America’s prosperity is not evenly shared. For example, while he notes that everyone in his upper-middle class neighborhood enjoys a living standard better than that enjoyed by John D. Rockefeller, he also notes that “though the pie to be shared by the next generation will be far larger than today’s, how it will be shared will remain fiercely contentious.” There will be, be “struggles for the increased output of goods” among various groups, including between those with talents that are valued highly by the marketplace and the equally decent hard-working Americans who lack the skills the market prizes.” Clashes of that sort “have forever been with us – and will forever continue.” Congress, he adds, will be there battleground were these disputes are sorted out.
Buffett returns to these same issues and themes in a later part of his essay where he reviews the dramatic impact that increases in productivity during the 20th and early 21st centuries have had on American society. To show how productivity has both improved and helped to shape society for the better, he looks first at American agriculture, in which vastly greater quantities of crops are now produced on equivalent quantities of land, using fewer workers. Buffett then looks at the productivity gains that have achieved over recent decades in several of the businesses that Berkshire owns, including, for example, the company’s railroad businesses. In each case, the business are producing far more outputs, revenues and wealth than in the past, again, frequently requiring fewer workers to achieve these results.
Buffett reviews these examples to show “the linkage between productivity and prosperity.” The productivity gains, he says, have “delivered awesome benefits to society,” as a result of which “our citizens, as a whole, have enjoyed – and will continue to enjoy – major gains in the goods and services they receive.” There are, however, “offsets.” First, Buffett acknowledges, the productivity gains have “largely benefitted the wealthy.” Second, productivity gains “frequently cause upheaval,” as both capital and labor “can pay a terrible price when innovation or new efficiencies upend their worlds.” We need not, Buffett adds, shed tears for capitalists, since they can gain large rewards, and also because “investors who diversify and simply sit tight with their holdings are certain to prosper: In America, gains from winning investments have always far more than offset the losses from clunkers.”
The problems for labor from the disruptive effects arising from improvements in productivity are more troublesome. Buffett reflects that jobs that were lost when his Maine-based shoe manufacturer lost out to Asian competition, or when Berkshire’s New England-based textile plant was unable to continue. The answer to these disruptions “is not the restraining or outlawing of actions that increase productivity,” since we would not be living nearly so well if, for example, we had mandated that 11 million people should forever be employed in farming. The solution, according to Buffett, “is a variety of safety nets” aimed at allowing those who are willing to work but who find their talents are deemed of small value due to market forces. He notes that he personally valued increased earned income tax credits. He concludes this analysis about productivity, prosperity, and economic change with an observation that “the price of achieving ever-increasing prosperity for the great majority of Americans should not be penury for the unfortunate.”
Buffett’s tone for most the letter reflects this same benevolent and optimistic point of view. However, his essay also includes a sobering assessment of risk, which presents a significant contrast with the more upbeat aspects of his letter.
After first noting that because of its diverse array of businesses, Berkshire has advantages over one-industry companies, Buffett observes that there is “one clear, present and enduring danger to Berkshire” against which the company’s management is “powerless,” a risk that Berkshire shares with every American business; that is, the threat of a successful “cyber, biological, nuclear or chemical attack in the United States.” The threat of such mass destruction in any given year is “likely very small”; however, what is a small probability in a short period “approaches certainty in the longer run.” The added bad news is that there are “people and organizations and perhaps even nations that would like to inflict maximum damage on our country,” and their means of doing so “have increased exponentially in my lifetime.”
Chillingly, Buffett adds that “there is no way for American corporations or their investors to shed this risk.” If a mass devastation event occurs in the United States “the value of all equity investments will almost certainly be decimated.” Buffett closes by repeating Einstein’s observation that he did not know with what weapons World War III will be fought, but “World War IV will be fought with sticks and stones.”
With this disturbing assessment that the probability of a successful act of mass destruction is, over the long run, both approaching certainty and unavoidable, the significance of Buffett’s other comments shrink to the point of insignificance. For the benefit of those who are interested in hearing what else Buffett had to say, I note a couple of other interesting observations in the letter.
First, readers of this blog will be interested to hear what Buffett had to say about the future prospects in the insurance business, and the particularly dismal future prospects for the reinsurance. Buffett opens his discussion Berkshire’s insurance business with a review of his familiar tribute to the virtues of insurance “float”; that is, the money that insurance companies hold, and invest, in order to be able to pay claims. He notes the abilities of the Berkshire insurance business to produce – and indeed, to increase – the available float. He also notes that the Berkshire insurance business have produced underwriting profits for 13 consecutive years.
However, the insurance business as a whole is intensely competitive, which sometimes causes the industry to operate at a significant underwriting loss. The industry has a “dismal record” of earning “subnormal returns on tangible net worth” compared to other American businesses. These disadvantageous business conditions are exacerbated by the prolonged period of low interest rates which “virtually guarantees that earnings on float will steadily decrease for many years to come.” As a result, Buffett says, “It’s a good bet that industry results over the next ten years will fall short of those recorded in the past decade, particularly for those companies that specialize in reinsurance.” (Given Buffett’s remarks about the dismal future prospects for reinsurance, it probably comes as no surprise, in a different part of the letter, Buffett notes that the company’s insurance businesses are more stable than they were a decade ago because the company has deemphasized catastrophe coverages and greatly expanded “our bread-and-butter lines of business.”)
Readers may also be interested in Buffett’s extended remarks about Berkshire’s mobile home business, Clayton Homes. Some readers may find it surprising that Buffett devotes 17 paragraphs and nearly two pages of his annual report to this relatively small part of Berkshire’s overall operations. The explanation to Buffett’s extended discussion of this business can be seen from the fact that most of the discussion has to do with the business’s mortgage lending operations. There was a spate of publicity during 2015 that criticized Clayton Home’s lending to home buyers; the media coverage suggested that the company’s lending operations preyed on the poor and trapped low income borrowers in high-interest loans secured by depreciating assets. Buffett takes great pains to explain and justify the mobile home company’s lending operations. He particularly emphasizes the way the company performed during the financial crisis, when other companies were bailing out of the business or leaving home owners in the lurch.
I will leave it to others to assess whether or not they think Buffett’s defense of Clayton is successful. There is one part of Buffett’s discussion I wanted to be sure to point out, however. In discussing the excesses of the home mortgage business that helped contribute to the global financial crisis, Buffett notes that part of the problem at the time was that Wall Street had bundled home mortgages into complex financial instruments that few could truly comprehend or understand. In an observation that can only be called ironic, Buffett adds in an aside that “It’s also questionable as to whether the major rating agencies were capable of evaluating the more complex structures. But rate them they did.”
Just two pages following this observation about the rating agencies, there is a chart that shows that among Berkshire’s fifteen largest common stock investments is Moody’s. Yes, that Moody’s, one of those previously unnamed rating agencies that may not have understood but nevertheless rated Wall Street’s complex mortgage-backed securities. Nor is this Moody’s investment a new one; I looked back at Buffett’s letters to shareholders, and Moody’s was listed among Berkshire’s largest investment holdings in each of Buffett’s letters in 2005, 2006 and 2007, the years when the worst of the excesses in the housing market and on Wall Street were at their peak. Buffett may have sharp words about the rating agencies but Berkshire has nevertheless held and continues to hold a substantial part of its significant investment in Moody’s.
Buffett’s strong vote of confidence in the resilience of and future prospects for the American economy provide a refreshing contrast to the downbeat tone of certain Presidential candidates. Not everyone will be persuaded by his comments about the how the harsher effects resulting from productivity gains can be ameliorated, but at least he acknowledged the problem and suggested some ways to try to address the issues. He does in any event make the important point that changes resulting from productivity gains have both been an important part of our prosperity and a serious source of disruption for most of the last century. Overall, the country has been significantly better off as result of these changes, even though the process has produced winners and losers. Buffett’s message, and it is an important one, is that those who come out on the short end of these changes should not be forgotten, and that as a society we should take steps to aid those who disruptive change has displaced.
I find all of Buffett’s comments about America’s prospects reassuring. However, the comforting value of his observations is pretty much undermined by his disturbing comments about the likelihood of success of an act of mass destruction. Personally, it is not enough for me to hear that these kinds of attacks may be both inevitable in the long run and impossible to prevent. Buffett is not a political leader, so perhaps he has no obligation to formulate what we must do if these are the realities we face. A private company’s letter to shareholders really isn’t the right forum for the extended discussion of these issues. But Buffett’s comments make me think there is a discussion we need to be having as a society; that is, we really do to decide if the risk is as Buffett suggests, and decide what we need to do as a society and what we expect from our political leaders as a result.
Some may find it puzzling how Buffett can allow the terrible possibility of an act of mass destruction is likely over the long run and yet at the same time contend that the future for America’s children is brighter than it has ever been. Buffett does not directly address that seeming contradiction in this year’s letter. However, I think part of the answer to this question may be found in remarks he has made in various forms in his letters over the past several years. That is, as he has several times noted, the country has faced dark days and terrible times in the past – for example, in April 1861, December 1941, September 2001, and September 2008, and yet it has always managed to find its way back, to become stronger than before. In his 2012 letter, Buffett mentioned that he bought his first stock in the spring of 1942, when the U.S. was sustaining a series of terrible losses in the Pacific war zone. Each day’s headlines told or more uncertainty; but there was never any doubt that the country would prevail, and the country fought its way back, as it always has. In other words, though Buffett is optimistic about the future, he doesn’t for a minute believe that only good things can happen. Indeed, he knows and he has seen that terrible things can happen. He just believes that the U.S. economy is stronger than the adversities that might arise, even terrible adversities.
On a far different and less momentous note, Buffett’s observations about the insurance industry are pretty bracing for those of us in the business, particularly for those who happen to be on the reinsurance side. I am guessing that it is probably not in the calculus of top managers at most insurance companies that the industry’s results for the next ten years will fall far short of its results for the last ten years. Anyone aware of the industry’s chronic overcapacity has to recognize the chance that Buffett’s assessment is correct, particularly given the low interest rate environment that has prevailed for some time now and that seems likely to continue. The implications could be significant. Indeed, we are already seeing some of the impacts from these forces at work. The wave of consolidations in the P&C industry represents one consequence, and the activist investor pressures on company management is another. If Buffett is right, we will see more and more of these kinds of developments in the years ahead.
I wanted to be sure to note that this year, for the first time, the Berkshire shareholders’ meeting will be live-streamed on the Internet. The meeting will take place on April 30, 2016 at 10:00 am EDT, and it can be viewed on the Internet here. If you have not seen a Berkshire shareholders’ meeting before you might want to take the time to watch the live stream. I am guessing most people will not have the stamina to watch the whole thing. It has been many years since I attended a Berkshire shareholders’ meeting, and having been to one, I have not even the slightest interest in going again. Nevertheless, I think most people would find it interesting and worthwhile to watch at least part of one, and now through the miracle of the Internet, everyone can “attend.”
For those who biggest concern with Berkshire is that Buffett will turn 86 this year, Buffett’s letter does not have much to say, at least not directly. There is nothing in the letter addressing succession plans or even trying to provide reassurances about the good hands in which he will be leaving the company. Buffett does make a funny quip in reference to the live-streaming of the annual meeting that makes a nod to this concern; in discussing the fact that the meeting will be live-streamed, he acknowledges that he is 85 and co-Chair Charlie Munger is 92, and that investors might “want to look in occasionally to make sure we hadn’t drifted off into la-la land.” With the advent of the Internet connection, shareholders won’t have to travel to Omaha to monitor how they are doing. He adds parenthetically, that in making their evaluations, investors should “allow for the fact that we didn’t look all that impressive when we were at our best.”
Buffett can make jokes because he is still clearly continuing to function. Just the same, my household happens to include someone of exactly the same age as Buffett. Obviously, every individual’s experience is their own, but I have seen first hand how quickly basic skills of the intellect can deteriorate. For all his humor (Buffett makes a joke that he intends to celebrate GEICO becoming the number one car insurer on his 100th birthday, August 30, 2030), Buffett is not immortal. At some point, he will no longer be able to run the company. This line of analysis can be pretty depressing for those who, like me, are heavily invested in Berkshire. I suspect that as in the past there was a Buffett premium in the Berkshire share price, there may be something of a debit now based on Buffett’s age.
While there certainly are good reasons to be concerned about what will happen when Buffett steps aside or moves on, there are also reasons to be optimistic, as is well-documented in George Washington University Law Professor Larry Cunningham’s 2014 book, Berkshire Beyond Buffett (which I reviewed here). Based on his comprehensive overview of the incredible company that Buffett has built, Cunningham concludes that what makes Berkshire unique is not Buffett himself; rather, it is the culture of the company. Berkshire, according to Cunningham “has distinct features and a strong corporate culture that will endure beyond Buffett.” And even beyond the distinctive culture, there is the incredible collection of businesses that Buffett has assembled. It is impossible to read Buffett’s letter to Berkshire shareholders without being astonished by the impressive array of types and kinds of businesses that he assembled – all of which that will continue to generate cash, earnings, and value long after Buffett has moved on.